ANALYSIS OF EQUITY INAS VALUATION RCT Cae oC SUC Ce RCT ARO OLN BCR ee aCe Dennis W. McLeavey, CFA oes Toad CiacciANALYSIS OF EQUITY INVESTMENTS: VALUATION John D. Stowe, CFA. University of Missouri—Columbia Thomas R. Robinson, CFA University of Miami Jerald E. Pinto, CFA TRM Services Dennis W. McLeavey, CFA Association for Investment Management and Research [ASSOCIATION FOR INVESTMENT MANAGEMENT AND RESEARCH®Le ‘To obtain the AIMR Product Catalog, contact: AIMR, PO. Box 3668, Charlottesville, Virginia 22903, U.S.A. Phone 434-951-5499 or 800-247-8132; Fax 434-951-5262; E-mail Info@aimcong ‘or visit AIMR's World Wide Web site at wwwalmeorg to view the AIMR publications list. CFA®, Chartered Financial Analyst®, GIPS®, and Financial Analysts Journal® are just a few of the trademarks ‘owned by the Association for Investment Management and Research®. To view a list of the Association for Investment Management and Research’s trademarks and the Guide for Use of AIMR’s Marks, please visit our ‘Web site at www.aimrorg. ©2002 by Association for Investment Management and Research, All tights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy. recording, or any information storage and retrieval system, without permission of the copyright holder. Requests for permission to make copies of any part of the work should be mailed 9: AIMR, Permissions Department, P.O. Box 3668, Charlottesville, VA 22903. ‘This publication is designed to provide accurate and authoritative information in regard tothe subject matter covered. It is sold with the understanding thatthe publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert asistance is required, the services of a competent professional should be sought. ISBN 0-935015-76.0 Printed in the United States of America by United Book Press, Inc., Baltimore, MD. ‘August 2002PREFACE Analysis of Equity Investments: Valuation represents the third step in an effort by the Asso- ciation for Investment Management and Research® (AIMR®) to produce a set of coordi nated, comprehensive, and practitioner-oriented textbook readings specifically designed for the three levels of the Chartered Financial Analyst® Program. The first step was the publication in June 2000 of two volumes on fixed income analysis and portfolio manage- ‘ment: Fixed Income Analysis for the Chartered Financial Analyst Program and Fixed Income Readings for the Chartered Financial Analyst Program. The second step was the publication in August 2001 of Quantitative Methods for Investment Analysis. Given the fa- vvorable reception of these books and the expected favorable reception of the current book, similar textbooks in other topic areas are planned for the future. ‘This book uses a blend of theory and practice to deliver the CFA® Candidate Body of Knowledge (CBOK) in the equity analysis portion ofthe curriculum. The CBOK is the re- sult of an extensive job analysis conducted periodically, most recently during 2000-01. Regional job analysis panels of CFA practitioners were formed in ten cities around the ‘world: Boston, Chicago, Hong Kong, London, Los Angeles, New York, Toronto, Seattle, ‘Tokyo, and Zurich. These and other panels of practitioners specified what the expert needs to know as the Global Body of Knowledge, and what the generalist needs to know as the CBOK. Analysis of Equity Investments: Valuation is a book reflecting the work of these expert panels. . In producing this book, AIMR drew on input from numerous CFA charterholder re- viewers, equity analysis specialist consultants, and AIMR professional staff members. The chapters were designed to include detailed learning outcome statements at the outset, illus- trative in-chapter problems with solutions, and extensive end-of-chapter questions and prob- lems with complete solutions, all prepared with CFA candidate distance learning in mind. ‘This treatment of equity analysis represents a substantial improvement for CFA candidates compared to the previous readings. Although designed with the CFA candidete in mind, the book should have broad appeal in both the academic and practitioner marketplaces. ‘AIMR Vice President Dennis McLeavey, CFA, spearheaded the effort to develop this, book. Dennis has a long and distinguished history of involvement with the CFA Program. Before joining AIMR full-time, Dennis served as a member of the Council of Examiners (the group that writes the CFA examinations), an examination reviewer, and an examina tion grader. Co-authors John Stowe, Tom Robinson, and Jerry Pinto bring unique perspec tives to the equity analysis process. John is a professor of nance and associate dean at the University of Missouri. Tom is an associate professor of accounting at the University of Miami, Jerry is an investment practitioner who has a successful consulting practice spe- cializing in portfolio management, All three are CFA charterholders and have served as CFA examination graders. In addition, Tom and John have served on the Council of Exam- iners, and Jemy and John have served as CFA examination standard setters (the group that provides @ recommended minimum passing score for the CFA examinations to the Board ‘of Govemors). We were fortunate that Jerry was able to take a leave of absence to work at AIMR on this project.Preface ‘The treatment in this volume is intended to communicate a practical equity valuation process for the investment generalist. Unlike many alternative works, the book integrates accounting and finance concepts, providing the evenness of subject matter treatment, con- sistency of notation, and continuity of topic coverage so critical to the leaning process. ‘The book does not simply deliver a collection of valuation models, but challenges the reader to determine which models are most appropriate for specific companies and situ tions. Perhaps the greatest improvement over previous materials is that this book contains ‘many real-life worked examples and problems with complete solutions. In addition, the ex- amples and problems reflect the global investment community. Starting from a U.S.-based program of approximately 2,000 examinees each year during the 1960s and 1970s, the CFA Program has evolved into a pervasive global certification program that currently in- volves over 101,000 candidates from 149 countries. Through curriculum improvements such as this book, the CFA Program should continue to appeal to new candidates across the ‘lobe in future years, Finally, the strong support of Tom Bowman and the AIMR Board of Govemors through their authorization of this book should be acknowledged. Without their encour- agement and support, this project, intended to materially enhance the CFA Program, could not have been possible. Robert R. Johnson, Ph.D., CFA Senior Vice President Association for Investment Management and Research July 2002ACKNOWLEDGEMENTS ‘We would like to acknowledge the assistance of many individuals who played a role in producing this book. Robert R. Johnson, CFA, Senior Vice President of Curriculum and Examinations (C&E) at AIMR, saw the need for specialized curriculum materials and initiated this project, at AIMR. Jan R. Squires, CFA, Vice President in C&E, contributed an orientation stressing ‘motivation and testability. His ideas, suggestions, and chapter reviews have helped to shape the project. Philip J. Young, CFA, Vice Presidentin C&E, provided a great deal of assistance with leaming outcome statements. Mary K. Erickson, CFA, Vice President in C&E, pro- vided chapter reviews with a concentration in accounting. Donald L. Tuttle, CFA, Vice Pres- ident in C&E, oversaw the entire job analysis project and provided invaluable guidance on what the generalist needs to know. ‘The Executive Advisory Board of the Candidate Curriculum Committee provided invaluable input: Chair, Peter B. Mackey, CFA, and members James W. Bronson, CFA, ‘Alan M. Meder, CFA, and Matthew H. Scanlan, CFA, as well as the Candidate Curricu- Jum Committee Working Body. Detailed manuscript reviews were provided by Michelle R. Clayman, CFA, John H. Crockett, Jr, CFA, Thomas J. Franckowiak, CFA, Richard D. Frizell, CFA, Jacques R. Gagne, CFA, Mark E. Henning, CFA, Bradley J. Herndon, CFA, Joanne L. Infantino, CFA, Muhammad J. Iqbal, CFA, Robert N. MacGovern, CFA, Farhan Mahmood, CFA, Richard K. C. Mak, CFA, Edgar A. Norton, CFA, William L. Randolph, CFA, Raymond D. Rath, CFA, Teoh Kok Lin, CFA, Lisa R. Weiss, CFA, and Yap Teong Keat, CFA. Detailed proofreading was performed by Dorothy C. Kelly; CFA, and Gregory M. Noronha, CFA: Copy editing was done by Fiona Russell, and cover design is by Lisa Smith, Associate at AIMR. ‘Wanda Lauziere, C&E Associate at AIMR, served as project manager and guided the book through production.ABOUT THE AUTHORS John D. Stowe, Ph.D., CFA is a Professor of Finance and Associate Dean at the Univer- sity of Missouri-Columbia where he teaches investments and corporate finance. He ‘eamed the CFA charter in 1995 and started CFA grading in 1996. He has served on the Candidate Curriculum Committee, the Council of Examiners, and in other voluntary roles at AIMR, and is a member of the Saint Louis Society of Financial Analysts. He has won several teaching awards and has published frequently in academic and professional jour- nals in finance. He is a co-author of a college-level textbook in corporate finance. He eamed his B.A. from Centenary College and his Ph.D. in economics from the University of Houston. ‘Thomas R. Robinson, Ph.D., CPA, CFP, CFA is an Associate Professor of Accounting at the University of Miami where he primarily teaches Financial Statement Analysis. Profes- sor Robinson received his B.A. in economics from the University of Pennsylvania and Master of Accountancy from Case Western Reserve University. He practiced public ac- counting for ten years prior to eaming his Ph.D. in accounting with a minor in finance from Case Western Reserve University. He has won several teaching awards and has published regularly in academic and professional journals. He is currently Senior Investment Consul- tant for Earl M, Foster Associates, a private investment management firm in Miami, and previously served as a consultant on financial statement analysis and valuation issues. Pro- fessor Robinson is active locally and nationally with AIMR and has served on several com- mittees including AIMR’s Financial Accounting Policy Committee. He is past president and a current board member of the Miami Society of Financial Analysts. Jerald E, Pinto, CFA, as principal of TRM Services, consults to corporations, founda- tions, and partnerships in investment planning, portfolio analysis, and quantitative analy- sis, Mr. Pinto previously taught finance at the NYU Stern School of Business after working in the banking and investment industries in New York City. He is a co-author of AIMR’s text, Quantitative Methods for Investment Analysis. He holds an MBA from Baruch College anid a Ph.D. in finance from the Stern School. During the writing of this book, Mr. Pinto was 2 Visiting Scholar at AIMR. Dennis W. McLeavey, CFA is a Vice President in the Curriculum and Examinations Department at AIMR. He eamed his CFA charter in 1990 and began CFA grading in 1995. During the early 1990s, he taught in the Boston University and the Boston Secu- rity Analysts’ CFA review programs. He subsequently served on the AIMR Council of Examiners and is now cesponsible for new curriculum development at AIMR. He is a co- author of AIMR’s text, Quantitative Methods for Investment Analysis. After studying economics for his bachelor’s degree at the University of Westem Ontario in 1968, he ‘completed a doctorate in production management and industrial engineering at Indiana University in 1972.About the Authors George H. Troughton, Ph.D., CFA is a Professor of Finance at California State Univer- sity, Chico. He was formerly Professor of Finance at Babson College in Wellesley, MA. He has also worked as an equity analyst at Lehman Brothers and Scudder, Stevens and Clark. He has served in numerous capacities at AIMR including the Candidate Curriculum Com- mittee, the Council of Examiners, and the Editorial Board of The CFA Digest. In 1999 he ‘was recipient of the C. Stewart Sheppard Award for the advancement of education in the investment profession. He has graded CFA exams since 1982, and in 2002 was awarded the Donald L. Tuttle Award for CFA Grading Excellence. Professor Troughton holds an AB from Brown University, an MBA from Columbia University, and a Ph.D. in finance from the University of Massachusetts-Amherst.Contents xiii cnarrer D 5 PRICETO SALES 5.1 Determining Sales 5.2. Valuation Based on Forecasted Fundamentals 5.3 Valuation Using Comparables 6 PRICETO CASH FLOW 6.1 Determining Cash Flow 6.2 Valuation Based on Forecasted Fundamentals 6.3. Valuation Using Comparables 7 ENTERPRISE VALUE TO EBITDA 1g EBITDA 7.2. Valuation Based on Forecasted Fundamentals 7.3. Valuation Using Comparables 8 DIVIDEND YIELD 8.1 Calculation of Dividend Yield 8.2 Valuation Based on Forecasted Fundamentals 8.3. Valuation Using Comparables 9 INTERNATIONAL VALUATION CONSIDERATIONS 10 MOMENTUM VALUATION INDICATORS 17 VALUATION INDICATORS AND INVESTMENT MANAGEMENT 12 SUMMARY PROBLEMS, SOLUTIONS RESIDUAL INCOME VALUATION 1 INTRODUCTION 2 RESIDUAL INCOME 2.1 Commercial (mplementations 3 THE RESIDUAL INCOME VALUATION MODEL 3.1 The General Residual Income Model 3.2. Fundamental Determinants of Residual Income 3.3 Residual Income Valuation in Relation to Other Approaches 4 ACCOUNTING AND INTERNATIONAL CONSIDERATIONS 4.1 Violations of the Clean Surplus Relationship 4.2. Balance Sheet Adjustments for Fair Value 4.3 Intangible Assets 4.4 Nonrecurring Items 4.5 Other Aggressive Accounting Practices 4.6 International Considerations 5. SINGLE-STAGE RESIDUAL INCOME VALUATION MULTISTAGE RESIDUAL INCOME VALUATION, 7 SUMMARY PROBLEMS SOLUTIONS REFERENCES GLossaRY INDEX 216 27 219 220 222 223, m8 229 229 233 233, 236 237 238 241 247 234 261 262 262 265 266 an 275 276 277 278 280 280 283 283 284 285 286 291 294 298 305 309 315Foreword the Analysis Journal (now the Financial Analysts Journal) in January 1943, Graham summarized the issue as follows: “The crux of the question is whether security analysis 1s a calling has enough of the professional attribute to justify the requirement that its practitioners present to the public evidence of fitness for their work.”” It took almost two decades to decide that question in the affirmative, but in June 1963, some 300 security analysts sat for the examination that would ear them the designation of Chartered Financial Analyst. In the first decade of the CFA Study Program, the primary valuation text for Level II candidates was the fourth edition of Graham and Dodd's Security Analysis. That book stressed a philosophy of investing centered on the concept of “intrinsic valve.” In view, distinguishing investment from speculation is essential: «_« « «investment is grounded on the past whereas speculation looks primarily to the future. But this statement is far from complete. Both investment and speculation ‘must meet the test of the future; they are subject to its vicissitudes and are judged by its verdict. But what we have said about the analyst and the future applies equally well to the concept of investment. For investment, the future is something to be guarded against rather than to be profited from. Ifthe future brings improvement, so ‘auch the better; but investment as such cannot be founded in any important degree ‘upon the expectation of improvement. Speculation, on the other hand, may always propetly—and often soundly—derive its basis and its justification from prospective developments that differ from past performance.* Graham and Dodd stipulated that investing, as opposed to speculating, requires either the purchase of leading issues (such as growth stocks) at prices within a range of their intrinsic value or the purchase of secondary issues (such as cyclical stocks) at bargain prices. Intrinsic value must be determined independent of market price, and the most important factor in determining a security's intrinsic value is a forecast of “earning power.” ‘An additional criterion that distinguished investment from speculation was that the investment asset's earning power should provide a margin of safety. When analyzing bonds and preferred stock, the analyst had to determine whether the securities had sufficient earn- ing power in excess of interest and preferred stock dividend requirements. When analyzing, common stocks, the analyst had to forecast earning power and multiply that prediction by an appropriate capitalization factor. Earning power was the unifying factor in determining the attractiveness of all securities, from the highest-grade bond down to the secondary ‘common stocks that were considered investment opportunities because their prices were well below indicated minimum intrinsic values. In investing, analysts counted on diversifi- cation to offset the recognized risk of individual securities. Itis interesting to contrast Graham and Dodd's philosophy to the way equity security analysts plied their trade in the so-called New Economy of the late 1990s. In an examina- tion of 28 analyst reports on Intel Corporation stock, Bradford Comell found litte estima- tion of fundamental value but a lot of focus on short-term revenue growth.” He found that ‘Taney Regan, The Intute of Chartered Faancial Analysts: A Twenty-Five Year History (Chariotesville, VA: ‘The laste of Chartered Financial Analysts, 1987), p. 5. * Benjamin Graham, David L. Dod, and Sidney Cote, Security Analysis, th edition (New York: MeGraw- Hill, 1962, p. 52 * Bradford Comell, “Is the Response of Analysts to Information Consistent with Fundamental Valuation? The Case of Ine” Financial Management, Spring 2001.